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Prepare the ground for effective contract administration: the UK’s Privy Council looks at termination risks and the employer’s rights of set-off under the FIDIC red book

Introductory remarks The UK’s Privy Council recently considered the interpretation of two clauses in the FIDIC Red Book 1999, concerning the obligations of an employer to evidence financial arrangements and to notify employer’s claims1.

The Privy Council, hearing an appeal from the Court of Appeal of the Republic of Trinidad and Tobago, adopted a strict approach to both of these matters. As a result, employers operating under FIDIC contracts should give careful consideration to this decision, which highlights the importance of good and timely contract administration, in order to avoid landing themselves in hot water.

The facts National Insurance Property Development Company Limited (NIPDC), as employer, appointed NH International (Caribbean) Limited (NHIC), as contractor, in 2003 to construct a hospital in Tobago.

The contract was based on the FIDIC Red Book 1999. In 2006, NHIC suspended and then terminated the contract, on the basis that the employer had failed to comply with clause 2.4, which obliged NIPDC to provide “reasonable evidence” that financial arrangements had been made and were being maintained in order to enable the employer to comply with its payment obligations.

Several disputes were then referred to an arbitrator, two of which were appealed to the Court of Appeal of Trinidad and Tobago. The Privy Council had to consider two issues:

NIPDC’s ability to raise counterclaims following termination

Whether NHIC had rightfully terminated the contract

A strict approach to the notification of employer’s claims NIPDC raised various counterclaims as part of the financial assessment following the termination.

NHIC challenged these counterclaims on the basis that clause 2.5 of the FIDIC Red Book obliges the employer to give notice of any claims “as soon as practicable” after it becomes aware of the event or circumstance giving rise to the claim. Clause 2.5 goes on to state that: “The Employer shall only be entitled to set off against or make any deduction from an amount certified in a Payment Certificate, or to otherwise claim against the Contractor, in accordance with this Sub-Clause.” (emphasis added)

The arbitrator took the view, which was upheld by the Court of Appeal, that clause 2.5 was not sufficient to bar NIPDC’s counterclaims in these circumstances. This was on the basis that the clause was limited to set-off against amounts certified in a payment certificate and could not serve to exclude or limit the employer’s common law rights of set-off and/or abatement of legitimate cross-claims.

The Privy Council took a different view. It considered that, given the use of the word “otherwise”, the wording of clause 2.5 could not be clearer and applied to any employer’s claims, whether or not they are intended to be relied on as set-offs or cross-claims. To be successful, therefore, any employer’s claim needs to be notified as soon as practicable and in compliance with the other provisions of the clause2.

This can be contrasted with the contractor’s obligation to notify claims under clause 20 of the FIDIC Red Book. For example, in Obrascon Huarte Lain SA v Her Majesty’s Attorney General for Gibraltar3, the Technology and Construction Court in London saw no reason why the clause should be construed strictly against the contractor and saw reason why it should be construed reasonably broadly. The court held that the clause did not call for any particular form and should be construed as permitting any claim, provided it is made in writing to the engineer, the notice describes the event or circumstance relied on, and that the notice is intended to notify a claim for extension of time and/or additional payment. The court added that the notice “must be recognisable as a “claim””.

The Privy Council’s decision is a warning to employers that courts and tribunals applying English law will take a stricter line when looking at compliance with the requirements in respect of employer’s claims, both in terms of the timing and content of notices.

It is clear that employers must notify all and any claims without delay. The Privy Council did not, however, seek to opine on what time period might comply with the “as soon as practicable” requirement. Unlike clause 20, there is no maximum 28-day cut-off for claims in clause 2.5, so, what may or may not amount to a compliant notification is going to depend on the facts in each case.

In addition, along with the notice, the employer must provide particulars specifying the clause or other basis of the claim and substantiation of the amount claimed and/or extension to which the employer considers itself entitled.

Obligations of an employer to evidence financial arrangements The assessment of NHIC’s right to terminate turned on analysis of letters issued by the permanent secretary at the Tobago Ministry of Health, which assured the contractor that the government would meet the financial requirements for the project. However, the letters did not contain specific confirmation of approval by the Cabinet to payment of sums due, which was required for this project.

The arbitrator considered that the evidence was not sufficient. Clause 2.4 required more than just showing the employer was able to pay, it needed evidence of positive steps that the financial arrangements had been made. The Court of Appeal disagreed and considered that the arbitrator was demanding the “highest standard” rather than “reasonable evidence”.

The Privy Council held that the arbitrator had erred in law as to one of his reasons for holding that the termination was valid. However, that did not infect his first and main reason, which it duly upheld. As a result, the Privy Council confirmed the arbitrator’s decision that the contract was validly terminated.

The case serves as a useful illustration of the dangers of this clause. If left un-amended by the parties, there is considerable scope for disagreement as to what constitutes “reasonable evidence”. Given that a breach of this clause entitles the contractor to terminate the contract, the consequences of getting this wrong can be severe for an employer.

Recommendations for contract negotiation and administration

The Privy Council has expressed its view as to what FIDIC, and, therefore, the parties, intended by clause 2.5 in its un-amended form.

As a result of this decision, employers should ensure that any claims arising during the course of a project are promptly notified to the contractor. The same analysis is likely to apply to contractors making claims under a FIDIC-based sub-contract if equivalent clauses are included.

During contract negotiations, contractors will, no doubt, want the certainty provided by clause 2.5 to be maintained, whereas employers may be minded to seek an amendment to soften its effects.

FIDIC recognised in clause 2.4 the importance to the contractor of the employer’s ability to comply with its payment obligations. Indeed this was one of a small number of contractor-friendly provisions introduced by FIDIC in its Red Book 1999.

So as to provide greater certainty, it would be sensible for an employer to identify at tender stage what evidence it is prepared to give and for clause 2.4 to be amended so as to specify precisely what is to be provided.

Alternatively, in order to achieve FIDIC’s objective, the parties may agree to replace clause 2.4 with a more specific obligation, such as a requirement for the provision of a payment guarantee or the setting-up of a project bank account.

Finally, as ever, the message to employers (or their engineers), and contractors for that matter, is that they must manage the risks under the contract through diligent and timely contract administration.

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Compare jurisdictions: Litigation: Enforcement of Foreign Judgments

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